When we borrow and then pay back with interest, it’s how banks make money. The cost of borrowing, known as the interest rate, can make a big difference in which credit card you choose or whether you decide to get one at all.
But if your bank wants to make it more expensive or cheaper to borrow, it’s not as simple as just slapping on a new rate, as a grocer would with milk prices.
? How the Federal Reserve affects mortgage rates
One thing homebuyers sometimes misunderstand is how the Federal Reserve affects traditional mortgage rates. The Fed doesn’t actually set mortgage rates. Instead, it determines the federal funds rate, which generally impacts short-term and variable (adjustable) interest rates.
This is the rate at which banks and other financial institutions lend money to one another overnight to meet mandated reserve levels. When the federal funds rate increases, it becomes more expensive for banks to borrow from other banks. Those higher costs may be passed on to consumers in the form of higher interest rates on lines of credit, auto loans and to some extent mortgages.
Traditional mortgage rates are influenced by a number of factors, including Federal Reserve monetary policy, which includes both the federal funds rate and buying and selling of government securities such as bonds.
? How do rates go up or down?
Banks don’t lend only to consumers; they lend to one another as well. That’s because at the end of every day they need to have a certain amount of capital in their reserves. As regular people with bank accounts spend money, that balance fluctuates, so a bank may need to borrow overnight to meet the minimum capital requirement.
And just as they charge you for a loan, they charge one another. The Fed tries to influence that charge, called the federal funds rate. When the fed funds rate falls, banks also lower the rates they charge consumers, so borrowing costs decrease.
Floor and ceiling
After the Great Recession, the Fed bought an unprecedented amount in government bonds, or Treasurys, to inject cash into banks’ accounts. Nearly $2 trillion in excess reserves was accumulated with the Fed. (There was less than $500 billion in 2008.)
The Fed decided that one way to pare down this stockpile of Treasurys was to lend some to money-market mutual funds and other dealers. It does this in transactions known as reverse repurchase operations, which involve selling the Treasurys and agreeing to buy them back the next day. The Fed sets a lower “floor” rate on these so-called repos.
Then it sets a higher rate that controls how much it pays banks to hold their cash, known as interest on excess reserves. This acts as a ceiling, since banks won’t want to lend to one another at a rate lower than what the Fed is paying them — at least in theory.
Take advantage of rising rates to boost your home savings fund
While it’s important to understand how rising interest rates affect home prices, it’s also key to know that rising interest rates actually provide more of an incentive to save, for both the upfront and long-term costs of buying. While banks may be charging more for loans, they could also be paying out a slightly higher interest rate on savings accounts.
If you’re trying to accelerate your down payment fund or set aside cash for closing costs, every extra penny earned in interest counts. Even if you’re planning on staying put in your rental for the moment, you can still take advantage of higher savings account yields so that when you’re ready to buy, you’ll have the money waiting for you.
? Why does the Fed raise interest rates?
Periodically, the Fed raises interest rates. More specifically, it raises the federal funds rate, which in turn impacts borrowers’ interest rates on things like credit cards and home equity loans, and, more indirectly, fixed-rate home loans.
So why does the Fed raise interest rates at all? Because it helps keep inflation in check. When rates are too low, cheap borrowing can overheat an economy. Prices rise as demand for goods and services goes up, but the Fed can counteract inflation by increasing rates, thereby curbing consumption. Conversely, the Fed can fight deflation by lowering interest rates. Cheap money spurs spending and demand for goods, helping to increase prices in an economy.
Final Thoughts
The Federal Reserve aims to maintain economic stability and impact bank lending rates. When the Fed wants to boost the economy, it typically becomes less expensive to take out a mortgage, and when the Fed wants to clamp down on the economy, it acts to drain money from the system, which means borrowers will likely pay a higher interest rate on mortgages.